The International Financial Institutions: A View from the IMF

Professor Sacasa and distinguished representatives of the banking community,
UnderSecretary Geithner, my dear colleague, Vice President Marc Malloch Brown, Ladies
and Gentlemen. Over the past year or so, the crises in Asia and then in Russia have led to
increasing calls for "structural adjustments" of the international financial
institutions. Indeed, these calls have been wide ranging, and of course the IMF and its role
has not escaped the attention of policymakers, financial market participants, academics, and
other observers. It is my pleasure today to have the opportunity to provide on behalf of my
colleague, Stanley Fischer, the IMF’s views on how to change what has
come to be called the "international financial architecture".

At the outset, I would like to recall the remarks made by Stanley Fischer at last year’s
MidWinter Conference. At that time, in addition to reviewing the Asian crisis, Mr. Fischer
discussed the issues of moral hazard, the role of the IMF, and IMF resources. He concluded
emphatically that the approach argued by some as a way to respond to crises in emerging
market countries—that is, to simply let the chips fall where they may and not to come to
the assistance of these countries, thereby discouraging reckless behavior by borrowers and
lenders in the future—is not sensible. The result would be a deeper and more painful
adjustment for the countries concerned and also a greater negative impact on world trade and
growth. Therefore, the approach of doing whatever possible to mitigate the crisis through the
provision of international assistance and the implementation of appropriate policies remains
the preferred approach.

In that context, the responsibility of the international community, specifically the member
countries of the IMF, to provide adequate resources to the IMF to allow it to do its job was
also mentioned. It is indeed welcome that the international community has fulfilled this part
of its job of supporting the international financial system. Less than two weeks ago, on
January 22, members representing more than 85 percent of the total of IMF quota
subscriptions, or shareholdings, formally consented to the eleventh general review of quotas.
As a result, the capital base of the IMF will rise to almost $300 billion, and usable resources
by about $63 billion. Here I would like to acknowledge the support of your Association as a
member of the Ad Hoc Coalition for IMF Replenishment, which worked to help ensure the
approval of this quota increase in the U.S. Congress.

With this investment in the stability of the international financial system having been made, it
is our shared responsibility now to make continued progress on reforms to the system that
will make it perform better. I will now review the actions that have been taken to date and
present views on certain key issues.

The job of making the international system work better requires a strong cooperative effort to
institute reforms in the emerging market countries, in the industrial countries and of the
international financial institutions. In the emerging market countries, sound macroeconomic
policies and structural reforms to restore and maintain investor confidence and facilitate
stability of financial flows are, of course, the fundamental ingredient. With regard to the
latter, an important lesson from the recent crises is the importance of a healthy domestic
banking system as well as strong corporate financial practices (such as appropriate auditing
and accounting standard and efficient bankruptcy procedures).

On the policy front, one important specific issue is how to deal with capital flows from
abroad and guard against their possible reversal. In this connection, there has been support in
some circles for the approach taken by Malaysia of using capital controls. Our view is that the
case for liberal international capital flows remains valid, but that full liberalization requires
strong supervision and regulation and a strong underlying balance of payments. Otherwise,
openness will entail significant risks. And in that context, there may be a case for
market-based controls or taxes on short-term inflows often characterized as the Tobin tax,
even though even here I would note that the empirical evidence on the effectiveness of such
measures is mixed.

Another element of the changes needed in the emerging market countries is the provision of
better information to markets, to ensure the adequate assessment of the financial position of
these countries by both investors and policymakers. This will require efforts by the private
sector to adopt appropriate accounting and disclosure standards as well as efforts by
regulators to enforce them.

Moving to the industrial countries, the two main things they need to be doing are: (i) to
themselves pursue the right policies geared towards sustaining growth over time, for, of
course, without strong growth in these countries, the environment in the rest of the world will
be difficult; and (ii) to ensure the maintenance of strong financial systems in their own
countries. With regard to the latter, the contagion following the Russian financial crisis and
the LTCM case point to the need to review the adequacy of prudential regulations governing
hedge funds.

Let me turn now to reforms of the international financial institutions. It is widely agreed that
there are four areas where reforms would help to improve the functioning of the international
monetary system. These are: (i) steps to encourage the design and adoption of banking and
other relevant standards; (ii) steps to encourage the provision of better information to the
markets and to the public more generally; (iii) steps to strengthen surveillance of financial
developments and policies in individual countries; and (iv) possible changes in the lending
practices of the IFIs.

As already mentioned, the emerging market countries need to strengthen practices and
standards in both the financial and nonfinancial corporate sectors. As one step to encourage
these countries to adopt the recommended measures, the international community is placing
particular emphasis on the development and implementation of international standards and
principles. In the banking area, the Basle Committee on Banking Supervision has developed
the Core Principles for Effective Banking Supervision, which serves as the basic
reference and minimum standard for supervisory authorities, while the IMF has developed a
framework for financial sector surveillance to guide the identification of potential areas of
vulnerability. The Basle Committee will no doubt continue to be responsible for formulating
banking standards, and the IMF’s primary role will be to help monitor their adoption
and implementation.

International standards exist or are being developed in other areas as well. Universal
principles for securities market regulation and to improve disclosure standards are being
developed by IOSCO, International Accounting Standards have been published, and
international auditing standards have been established. Regional and multilateral initiatives to
harmonize domestic bankruptcy laws have not been successful, as domestic bankruptcy
systems vary considerably across countries due to differences in legal traditions and practices.
However, some progress in reforming bankruptcy legislation in individual countries has been
made in the context of IMF and World Bank lending programs.

On its part, the IMF has developed a Code of Good Practices on Fiscal Transparency to guide
member countries in enhancing the accountability and credibility of fiscal policy; members
are being encouraged to implement the Code on a voluntary basis. A similar code with
respect to monetary and financial policies is also being developed, in consultation with
central banks and multilateral financial supervisory authorities.

Considerable efforts are also underway to improve the provision of economic and financial
data to the public by emerging market countries. The IMF has established the Special Data
Dissemination Standard (SDDS) to guide its market-borrowing members on data
dissemination; currently, 46 countries are subscribers of the SDDS; and we are taking various
initiatives to improve the coverage of financial sector vulnerabilities in published data. At the
same time, the BIS is set to begin collecting information on over-the-counter derivatives
while also working to improve its recording and publication of information on international
bank lending.

The third broad way in which the IFIs can contribute to reducing the risk and costs of
financial crises is by strengthening the process of surveillance. Such surveillance by the IMF
and other multilateral institutions aims at facilitating the diagnosis of vulnerabilities to
potential crises and the prescription of suitable corrective policy actions. In addition, it would
help monitor the adoption of the various international standards and codes of conduct
discussed above, and perhaps even help enforce adherence to them.

IMF surveillance of member countries takes place mainly through the annual Article IV
consultation with each member on the state of its economy. This is what last week’s
Economist refers to as the IMF’s annual "health-check" of each of
its members. Article IV reports prepared by the staff are then discussed by the IMF’s
Executive Board. The reports themselves are generally not published, but information on the
consultation has been increasingly made public through the issuance of public information
notices (PINS), which summarize the Board discussion of Article IV reports. A member
country can block the publication of the PIN, but cannot edit it except for market-sensitive
material. Since their introduction a year and a half ago, an increasing percentage of countries
have agreed to the publication of PINS with over two-thirds of countries now agreeing.
Another important aspect of IMF surveillance has been its regular analyses of the global
economy and capital markets, which are reflected in the long-published World Economic
Outlook and the International Capital Markets Report.

Surveillance needs to be strengthened in two key respects. First, the monitoring of
international capital flows needs to be improved. This requires much better data than are now
available. Until recently, the BIS data on short-term international capital flows were available
only twice a year, with a six month lag. This meant that a foreign exchange crisis could arrive
and depart well before these data would even have provided a warning sign. The BIS is now
moving to quarterly data, with a one-month lag flows, but it would be preferable to have the
data available monthly. More generally, in monitoring international capital markets, the IMF
needs to continue to develop better contacts with market participants worldwide.

Second, to make surveillance more effective, it is essential to increase the incentives for
national authorities to pay serious attention to the policy messages and recommendations
contained that result from surveillance activities. The effectiveness of surveillance would be
improved if more IMF staff reports, especially Article IV reports, are published. This would
not only provide more information to the public, it would also improve the product by
ensuring that Fund analyses become subject to external appraisal. However, the issue is far
from straightforward. Some member countries and their governments argue that they are
vulnerable to IMF criticisms and thus the policy dialogue with IMF staff will be less than
fully frank if the Article IV reports were all to be published. One approach is to allow
countries that want to publish their Article IV reports to do so, as in the case of the PINs.

Strengthening surveillance procedures is no small task, especially since it will require
developing the information and expertise in a number of new areas. At the same time, I
should stress that we should not exaggerate the benefits of enhanced surveillance. Financial
sector problems have emerged in countries with the most sophisticated supervisory systems,
and better information cannot be expected to achieve miracles in preventing and minimizing
the potential costs of crises.

Finally, there are potential changes in IFI lending practices. As a response to the contagion in
the international system in recent years, the IMF is working to introduce a new contingency
lending facility which would make available potentially large sums of money to countries
following good policies. At the end of 1997, the IMF introduced the Supplementary Reserve
Facility, the SRF, which makes available short-term loans in large amounts at penalty rates to
countries in crisis, subject to policy conditionality. Similar to the SRF, financing under a
contingency facility would be on much shorter terms and with higher interest rates than
normal IMF funding. The difference, however, would be that the new facility would be a
precautionary one whereby countries threatened by but not yet in crisis would be able to
supplement their foreign reserves. A possible feature would be that countries could prequalify
for assistance under this facility, by establishing a good track record of policies. Also,
qualification for this facility could be used as an important incentive for countries to adopt
better standards and practices by restricting access to the new contingency lending facility
only to countries that meet specific standards.

There has been a fair bit of attention in this recent period to the use of guarantees from the
multilateral development banks to enhance the access of countries to the international capital
markets. The World Bank and Asian Development Bank have already provided such
guarantees to Asian countries. The use of guarantees makes sense in a crisis when capital
market access dries up, but should not become a regular feature of borrowing by emerging
market countries.

In the area of lending practices, the issue of how to "involve,"or "bail
in," the private sector is now a subject of hot debate. The question of moral hazard I
mentioned at the outset is of course relevant here. Without such an
"involvement," investors will exercise less caution than they should, in the belief
that the Fund will always be there to ensure that they are repaid. It must certainly be
recognized that most investors in all the recent crises have suffered very large losses.
Nonetheless, the moral hazard concern is valid. In addition, given the limits to the availability
of public resources, private sector participation may be needed in many cases if the debtor
country’s economic adjustment is to be accomplished without undue disruption and
hardship.

A number of approaches have been taken on this issue in previous crises and some new ones
are being considered for use in the future. In the debt crisis of the 1980s, IMF financing was
generally not provided until a critical mass of financing was available from the commercial
banks. This approach was easier when the banks were the main creditors and when the
country did not have wider market access—the situation that confronted Latin American
countries for much of the 1980s. When there are other lenders, however, an appeal to the
banks could lead to more rather than less outflows as the non-banks pull out. Moreover,
requiring banks, or any other creditors, to always share in the financing of the IMF programs
could be destabilizing for the international system. If that were the case, investors would be
more likely to run at the mere possibility of a crisis. In fact, countries approaching the IMF
for recent programs have been concerned that a formalized participation could hinder both
current investor sentiment and future market access. They argue, rather, that the successful
implementation of their program, combined with IMF and other official support, should be
enough to reassure investors and lead them to roll over credits voluntarily. This is a very
difficult question to resolve. One cannot but conclude that a case-by-case approach that
depends on the circumstances of each country seems best: sometimes a formal solution may
be a necessity, as in Korea in 1997; at other times a less formal approach would be better.

A second way to involve the private sector would be along the lines of that already discussed,
namely, precautionary guarantee arrangements involving multilateral banks, as were applied
previously in Argentina. A third would be to modify bond contracts to permit them to be
restructured by majority consent of creditors in the event of a crisis. A crisis, here, might be
defined by a set of objective indicators or by a formal declaration by the IMF.

A fourth approach is the more radical suggestion that the system needs the ability to in effect
declare a country bankrupt and provide an orderly framework for a debt workout. The IMF,
for example, could be given the power to declare a moratorium on payments by a member
country in difficulty, which would provide time for the country to work out a restructuring of
its debts with its creditors. One key issue here is that if the debt is private, it should stay
so—for the government to assume the debt, as was the case in Korea, is certainly a
moral hazard and should be strongly discouraged. Rather, the moratorium should be confined
to permitting a delay in the transfer of local currency payments by private debtors into foreign
currency.

The bankruptcy approach deserves fuller consideration. A few years ago it seemed doubtful
that industrialized countries would cede to an international organization and authority to
interpose itself between the creditors and foreign debtors. Nevertheless, they may be more
receptive to change after the experience of the last few years.

To conclude, taken together, the proposed changes would certainly reform the international
system, but not create a radically new system. Nor in our view is that necessary, for the
present system has been instrumental in producing more prosperity for more people than ever
before. By improving the quality of information, strengthening banking and financial
systems, and improving macroeconomic policies, and increasing the instruments available to
the international financial institutions, the proposed reforms should help reduce the frequency
and size of crises.

The reforms will be put in place gradually in the coming months and years. They will be
introduced only after further work has been completed, including work on the banking sector,
the creation, implementation, and monitoring of standards, and the regulation of hedge
fund-type activities. The international community has before it a formidable work program. It
must take up, evaluate, and act on the suggestions of the various official agencies and other
experts as rapidly as possible.